March 31. Financial conditions and the Fed… sounds boring, but it’s IMPORTANT

-In yesterday’s note I mentioned that we were “getting back into conundrum territory where the Fed raises short term rates, but the long end sits.” (www.chartpoint.com)   I mentioned that idea to Bill, who of course had to expound on the topic as if HE thought of it, and he felt compelled to use Financial Conditions in general as a topic of his speech yesterday.  Just kidding of course, but Dudley’s speech yesterday was an important one on several levels.  First, here’s the link, if you want to read it yourself and just skip my missive below.

https://www.newyorkfed.org/newsevents/speeches/2017/dud170330

I already saw a couple of hasty summaries from other market observers that I thought were off track; it’s always best to read the source.  Here are a couple of snippets.

To begin, let me be clear about what we mean by “financial conditions.”  Focusing on the United States, financial conditions can be broadly summarized by five key measures: short- and long-term Treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices. 

If financial conditions moved predictably with the policy rate, then there would be no need for the FOMC to focus on financial conditions.

Moreover, at times, we have observed cases in which financial conditions did not move in the same direction as the monetary policy stance.

Dudley mentions the 2004/06 hike cycle when long rates didn’t go up.  He cites other examples as well, and in this way is implicitly defending the Fed against the idea of ‘rules based’ decision making.  In fact, on one level you could say that’s what the speech was about: defending the Fed’s decisions and its independence.

–However, for our purposes, we’re more concerned about what this speech means for Fed policy in the near term.  Given that Dudley says the Fed has made progress on achieving employment and inflation goals, and that FF’s are still accommodative, let’s consider policy in the context of the financial conditions cited above.  Short term rates have gone up a bit due to tightening, but long term treasury rates have held steady or declined since the last two hikes.  Credit spreads are extremely tight.  The dollar has pulled off the highs.  Stocks are well higher than they were at the time of the December hike.  In other words, financial conditions really haven’t tightened at all.  Which would argue that the Fed should continue to hike at a steady pace.  Indeed, July Fed Funds had settled 9897.5 at the open-outcry close but traded immediately to 9896 on the speech.  He also talked a bit about the Fed’s balance sheet; too much for a morning comment but I will likely return to it over the weekend.  The CRITICAL takeaway is that both stocks and longer term treasuries may be in the Fed’s cross-hairs in terms of addressing ‘loose’ financial conditions.  That summary might be a stretch, but it’s worth keeping in mind.  Stocks and bonds don’t necessarily trade inversely.  Might have to write that on the chalkboard 100 times before it’s all over.

–One last little comment relating to yesterday’s market and financial conditions.  The May atm TYK straddle traded 1’00 yesterday with three weeks to go until expiry.  A friend (thanks ML) mentioned that he’s never seen the TY straddle trade 1 point this early in the cycle (I marked may vol at just 4.1).  Again, this pricing is somewhat reflective of complacency and loose conditions.

Posted on March 31, 2017 at 5:12 am by alexmanzara · Permalink
In: Eurodollar Options

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